Discussion Paper Series 2009-E-9

Financial Stability in Open Economies

Ippei Fujiwara, Yuki Teranishi

This paper investigates the implications for monetary policy of financial markets that are internationally integrated but have intrinsic frictions. When there is no other distortion than financial market imperfections in the form of staggered international loan contracts, financial stability, which here constitutes eliminating the inefficient fluctuations of loan premiums, is the optimal monetary policy in open economies, regardless of whether policy coordination is possible. Yet, the optimality of inward-looking monetary policy requires an extra condition, in addition to those included in previous studies on the optimal monetary policy in open economies. To make allocations between cooperative and noncooperative monetary policy coincide, the exchange rate risk must be perfectly covered by the banks. Otherwise, each central bank has an additional incentive to control the nominal exchange rate to favor firms in her own country by reducing the exchange rate risk.

Keywords: optimal monetary policy; policy coordination; global banking; international staggered loan contracts

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2009 Bank of Japan All Rights Reserved.

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